On My Radar: Stan Druckenmiller – Pieces of the Puzzle

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November 16, 2018
By Steve Blumenthal

“All I want out of life is that when I walk down the street, folks will say,‘There goes the greatest hitter that ever lived.'”

– Ted Williams

Ted Williams hit .344 lifetime and won six American League batting titles, despite losing five years to military service as a fighter pilot, first in World War II and later in the Korean War. He is the last MLB player to bat .400.

Williams went in the final day of the 1941 season guaranteed to hit .400, but elected to play a doubleheader in Philadelphia. He went 6-for-8, finishing at .406. Perhaps the greatest hitter of all time.

Today I want to share with you an interview with Stan Druckenmiller hosted by Real Vision and lead by investment visionary Kiril Sokoloff, chairman & founder of 13D Global Strategy & Research. Druckenmiller is the Ted Williams of investing. Perhaps the greatest investor of all time. He is a global macro investor with a track record that spans decades, has annualized returns near 30% and has never had a down year.

The last few years have been challenging he says due to distortion of price signals largely because of central bank intervention. The interview provides an opportunity to learn what he is seeing today and he shares a few secrets of his success. I love his unassuming and humble way.

Grab a coffee and find your favorite chair. When you click through, you’ll find the link to the full interview along with some of my shared notes. Real Vision has provided the interview to us for free. They are a subscription-based service and I’m personally a big fan of founders Raoul Pal and Grant Williams. I’m a new subscriber.

A quick aside: During the week, I often post to Twitter and LinkedIn a news article or chart or piece of research that may make it into On My Radar. What I like about Twitter is that you can follow specific people. My favorites include Ray Dalio, Howard Marks (buy his book), David Rosenberg, John Mauldin, Ian Bremmer, Ned Davis Research and others. Bloomberg’s Lisa Abramowitz is outstanding!

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Included in this week’s On My Radar:

Stan Druckenmiller – Pieces of the Puzzle

Watch Credit Conditions and High Yield Bond Market Signals

Trade Signals – No Major Changes to Signals; Equity Signals Remain in Buy, Though Weakening

Personal Note – Happy Thanksgiving

Stan Druckenmiller – Pieces of the Puzzle

Following are my notes. I begin at the 55 minute mark and go to near the end of the interview (around the 1:55 minute mark). I do encourage you to put your sneakers on, grab the dog, put your headphones in and take an hour walk. The first 55 minutes are well worth your time.

Stan: Everything for me has never been about earnings, has never been about politics, it’s always about liquidity. My assumption is one of these hikes, I don’t know which one, is going to trigger this thing. I am on triple red alert, because we are not only in the time frame, we are in the part (of the cycle), maybe markets don’t anticipate the way they used to. There’s no more Euro ECB money spilling over into the U.S. equity market. If we get a blow-off at the end of the fourth quarter, which typically tends to happen especially for the NASDAQ, particularly if theses bombs keep going off in the emerging markets, I could see myself taking a big shot somewhere around year end. But that’s still a long way off, right now I’m licking my wounds from the last shot I took.

Looks like yields are breaking higher on Japanese yields. For the world, this is part of the puzzle I’m talking about. In and of itself, I don’t know. But since it looks like this is happening, and at the same time the ECB will stop buying bonds, and it looks like at the same time we’ll be shrinking our balance sheet $50 billion a month. All of these pieces fit together for a reckoning. I’m not in the business to make a fortune if something goes from 10 bps to 20 bps, that’s not something I’m going to make a lot of money on. I might have a short on to amuse myself, but I do think it is very important in terms of the overall narrative. It’s also instructive as to why they are doing it. It looks like, from my read, that they are not doing it for economic reasons. They finally understand that it is killing their banks, which is the blood and the oxygen you need to run the economic body. And that’s causing a political problem. (In the U.S.) I sure hope it doesn’t take us 25 years of that kind of evidence before we normalize.

They’re all (Japanese Central Bank, ECB, Fed) going in the same direction which is why I made the (short to market) bet in June and July and I was wrong on a trading basis. But psychologically I’m still there. It is going to be the shrinkage of liquidity that triggers this thing. And frankly it has already triggered this in emerging markets. And that is kind of where it always starts. What I haven’t seen yet, and where I think we should see it before we see it in the equity markets, and God knows, talk about a crazy priced market it’s the credit market… and it’s amazing… probably since the 1880s-1890s, this is the most disruptive economic market in history, there are hardly any bankruptcies. So that Warren Buffett line about swimming naked when the tide goes out? There are probably so many zombies (companies) swimming out there and there is going to be some level of liquidity that triggers it… who knows, it might start with Tesla. I don’t know. I mean, could this Tesla thing happen in any other environment in history? It’s just ridiculous what’s been going on there in the last few weeks. But I don’t look at it so much that it’s Tesla, it just describes the environment to me. It’s just nuts.

Kiril: With all of the malinvestments and trillions of dollars that were spent without a cash return, you just can’t imagine how many zombies there really are out there and corporations buying back their stock to the tune of $5 trillion, running down their balance sheet. And then you go to the high yield market where it is covenant-lite and huge amount of issuance, what happens when interest rates start to reflect credit risk?

Stan: Intuitively, you can make a case that we are going to have a financial crisis bigger than the last one because all you did was triple down on what, in my opinion, caused it. Bernanke and I have a big disagreement over what caused that crisis, but to me the seeds of it were born in 2003 when we had 9% nominal growth in the fourth quarter and we had rates at 1%. And with that stupid “considerable period” thing attached to it (keeping rates low for a considerable period of time).

This caused serious malinvestments for three or four years. Subprime was pretty easy to identify if you had the right people showing you which, fortunately, I was lucky enough to have. I don’t know who the bogeyman is this time. I do know there are zombies out there. Are they going to infect the banking system the way they did the last time? I don’t know. What I do know is we seem to learn something from every crisis and this one we didn’t learn anything. In my opinion, we tripled down on what caused the crisis and we tripled down on it globally.

Kiril: We tried to solve the problem with more debt. That’s what we did in the 1920s and that didn’t work out.

Stan: With Wall Street just cheering them on.

Kiril: We’ve got this huge unfunded liability problem. A hundred trillion of Medicare, Medicaid and Social Security. That’s five times GDP. It’s just as bad in the rest of the world. Worst demographics in 500 years. Dependency ratios rising. You are going to have a battle between creditors and debtors at some point. Up to now the creditors have been winning but they are starting to lose a couple. When that plays out we are going to have some really tough times. Which brings me to this whole idea of populism. I want to try to bring this all together.

I started following populism back in 2011. That’s when I thought it was coming. Then we had Brazil. I came back from Beijing in October 2012 and it was clear to me that the new leadership was planning to clamp down on corruption to save the communist party. The word was to give a little bit now rather than a lot later. Unfortunately, in America, that didn’t happen. We’ve just gotten more wealth disparity. So populism, some people think it is represented by Trump and other people have different theories. My feeling is that populism is really about wealth divide. And an unequal sharing in the economy.

For 30 years the worker didn’t really get a wage increase. Now starting to get some, but it is being taken away from the higher cost of living. So when you look at this whole debt situation, you also have to look at it through this populism and this creditor vs. debtor situation. So how do you see this all playing out?

Stan: First of all, I think you nailed the cause of it because the previous populous periods we had required much worse economic situations to set them off. When I was running money for Soros, at year end for the first few years we had a fixed system for sharing the percentage of the profits. The rage the high performers felt about the low performers, even though they were all ridiculously overpaid, taught me that envy is one of the strongest human emotions. And when you look at the wealth disparity today, in my opinion, the biggest accelerant has been QE… it’s not even debatable. Then you have the internet broadcasting this disparity through millions of bits of information on an ongoing basis. I personally think Jeff Bezos deserves every penny he has. It’s one of the greatest companies ever. But there have been 20 articles in the last 40 hours, I bet you, that say he’s worth more than $150 billion. How does a normal citizen look at that and even contemplate it. So I think that is the seed of it. It’s not some economic malaise, it’s the disparity. It’s never been worse and probably one of the most disturbing books I’ve ever read was Charles Murray’s Coming Apart. This is going to get worse and it can’t stop. I don’t see what stops this until you end up with some major, major dislocations politically and economically because of it.

I agree with you that it’s not about Trump. Trump is clearly a populist but it’s globally. It’s everywhere. Other than Macron, there have been surprise after surprise to the elites on these elections and I wonder why they are surprised anymore.

Kiril: This leads me to America’s shift towards nationalism under Trump. The rest of the world is focusing on maintaining multi-lateral alignments. Japan has just signed with the EU and Mexico. TPP is powering ahead. We have the China One Belt. There is much controversy about it but I think it is tremendous, I think it is real. I understand why they are doing it. My question is, which is destined to win in the end (nationalism or globalism)?

Stan: The answer is I don’t know. Probably the most destructive thing Trump has done in the global trading system is figured out how powerful a weapon the U.S. banking system was and how powerful sanctions are… but he doesn’t understand that weapon is so powerful… Since the Marshall Plan on we have been the only country that all the others, no matter how they might bad mouth us, trusted us to do the right thing. We are the only nation in history who handled success the way we did. And yes, you should use this weapon once in a while, but when you start just shooting it all over the place and you are now shooting it at Canada, at Europe, at here, there and everywhere, it’s a lot different than shooting it at Iran. He’s like a little kid that found this water gun and is just running around all over the place with it. The biggest danger I see is that we lose that trust. That America is good and in the end, they are going to do the right thing. I don’t think that trust can be lost in four years. But if Trump is reelected or maybe even worse if another populist on the very hard left is elected and they use the weapon the same way I think by 2024, by the way it is exactly when the entitlement thing will start to get crazy, this thing could be very bad. I’m open minded… let’s see who the Democrats put up. Let’s see if Trump’s in office. But I don’t think the world will give up on us in four years. I’m open minded to Trump having been a one-off and our great system can survive this but it’s not like that’s an 80% probability, it’s probably somewhere between 40% and 55% that it works out. It’s sad.

Kiril: For sure. The whole supply chain issue is complicated. I’m concerned that the administration doesn’t understand the complexity and by trying to pull out all of the sensitive components from China and relocate them to the U.S. or to Vietnam, or wherever else is so immensely disruptive and dangerous, then you start a process… During the first part of the worst meeting in the trade negotiations between the Chinese and the Americans, I was in Beijing and then South Korea and I meet with Samsung. Already China was moving aggressively to create their own semiconductor business (having invested $150 billion). I asked Samsung what are you going to do if the Americans forbade you to sell semiconductors to China, will you continue to do so? I was told that they would. But they would also help China build their own industry even though it would cannibalize them. So I see these trends that are taking place that won’t be reversed. Europe, who would normally be an ally of America to try to hold back China’s advances, is now being forced more towards China and these are things that are not going to shift back because once you start to take these positions you are not going to reverse yourself.

Stan: I agree with you on the semiconductors and it emphasizes what you said earlier about these sort of “now” policies. Even if they worked and I could make an argument that they won’t work because if you disrupt the supply chain, everything is going to blow up. What you have done is absolutely put in force the creation of the Chinese semiconductor industry that didn’t need to happen in the time frame it is going to happen. I think there has been enough frustration with the Chinese that the Europeans could look at this and be right back there with us as allies again. But you are right, there are a lot of other things that are set in force that we are not going back to. I think you can make a good argument that some of the aspects of the China dispute are a fight worth fighting; you could also make an argument that they are not. But they are not a fight worth fighting without Europe and Canada and all these allies we’ve had… If you want to take on China, and fair people can debate on whether that should be done… but if you want to take on China, you can do it with a united front. You don’t do it by alienating all of your partners as the process gets underway.

Kiril: Especially when the U.S. is a net debtor to the tune of $8 trillion. Is running fiscal deficits that are close to what they were running in 2009… Stan jumps in: At full employment. If we are in a recession, that thing can go to $2 trillion in a heartbeat. That’s when deficits explode (sorry to interrupt Stan says). I think we are rolling over something like $10 trillion in nominal and new debt each year. We sold $130 billion in new debt in July, which is a record. And so the holders of our debt are the very people we are having a trade war with. Seems a little ironic to me.

Stan: It is what it is.

The interview concludes with Kiril asking Stan about him and his wife’s charitable interests. When I wrote the above, it required me to watch and replay the interview a number of times. I shared what I personally felt were the most important parts. I hope you got as much out of the interview as I did.

Watch Credit Conditions and High Yield Bond Market Signals

In my nearly 28 years of trading high yield bond instruments, it is the credit markets that signal first. Let’s keep a close eye on credit conditions. When funding disappears, we’ll quickly learn who the zombie companies are… it will be difficult for them to refinance. Defaults will follow. Two important charts follow, the first looks at credit conditions and the second the trend in the high yield space.

Credit Conditions

Here is how you read the chart:

Pay attention to the bottom section. It plots NDR’s Credit Conditions Index, which is a composite of many different types of indicators, ranging from valuation, to debt service, to balance sheet capacity, to the willingness of banks to lend.

The yellow circles highlight when the index dropped below a reading of 50.

Note how that occurred just prior to the last three recessions (grey vertical shaded areas).

Note the red “We are here” arrow.

Bottom line: Credit conditions remain favorable today.

High yield market via PIMCO HY Bond Fund

Here is how to read the chart:

Plotted is the total return price line of the PIMCO High Yield Bond mutual fund.

The green line is a 50-day smoothing of the price line.

Red arrows mark sell signals. I’ve selected several points in time when the price dropped below the smoothed moving average price line.

Note that there are many more signals, points when the price crossed the moving average line, than I’ve indicated. A trading strategy such as this has a high probability win rate at the cost of many whipsaws.

Given the enormous amount of poorly rated and covenant-lite debt (meaning bond holders get little asset recovery protection in default), keep a very close eye on the change in trend. Credit markets precede equity markets and the high yield market typically signals first.

Bottom line: High yield is in a sell signal. If credit conditions deteriorate (above chart), there will be no available liquidity for refunding. Defaults will hit record levels and the opportunity on the other side will be awesome.

Important note: Not a recommendation for you to buy or sell any security. For information purposes only. Please talk with your advisor about needs, goals, time horizon and risk tolerances.

Personal Note – Happy Thanksgiving

The snow swept through mid-afternoon yesterday. Watching it from the 46th floor in downtown Manhattan was both beautiful and well, ugh. Snow before Thanksgiving. I was not prepared. With five to seven inches in suburban Philadelphia already on the ground, I hit my Hotels Tonight app and extended my trip. The upside was a fun sushi dinner with my daughter, Brianna.

Mauldin and I hosted a small dinner Wednesday evening at Delmonico’s. Good friend Harry Glorikian wowed us with his presentation on digital media. Our plan is to host a number of dinners around the country in 2019. If you listen to the entire Druckenmiller interview, you’ll see the same “Great Reset” theme. Debt and pension liabilities that must get reset.

Druckenmiller now trades just for his own personal money. He said some of the biggest gains he has made have come from betting on the downside.

There is increasing evidence that we’ve entered a global bear market. Absent U.S. recession, history tells us to expect minus 20% or so in the U.S. markets. A non-recessionary bear market may have begun. It’s in the next recession that I believe we will see the real fireworks begin. I’ll keep posting the “recession watch dashboard” each week in Trade Signals.

I’m rushing to finish and get to the train. The kids are all coming home from college today. That makes Susan and me really happy. And, of course, next week is Thanksgiving. My personal favorite holiday of the year. All eight of us together at the dinner table. Love that!

My visit to Augusta last weekend was something I’ll cherish forever. Put a check mark next to item number one on my bucket list… I’m even more grateful for the time with our host and his son. Truly wonderful people. No pictures, no names… a full heart.

There will be no On My Radar post next Friday. I’ll be on the golf course with Matt and Brie and good friend, Stevie Oh. My golf club has an annual Black Friday Golf Tournament. It’s a four person scramble. We all tee off and pick the best drive, then all hit from that spot, pick the best shot and we then take the closest ball to the hole and we all putt from there. Lowest team score wins. Matt and Stevie are our ringers and Brie and I will do our best to help out… and that’s what makes it fun for all. Go team! The snow better melt.

From my family to yours… Wishing you a wonderful and safe Thanksgiving holiday.

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